On Sensitivity to Market Risk, Susceptibility and Vulnerability

In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago talks about the implications of the revelations about a rogue hedge fund operation at JPMorgan Chase.

It was a bit of a shock to me and many of our readers when the current trouble in JPMorgan's derivatives desk erupted. Not because the vulnerability to this type of problem in the desks of these big banks was not there - IRA's stress testing methodology has tracked off-balance sheet exposure as part of our CAMELS analysis regime for years -- but because I had not expected that this particular bank would be the one where this risk would first realize in the market place. In retrospect, that aspect of the letter S in the term CAMELS which stands for "sensitivity to market risk" is in fact uniformly distributed among the participants in derivatives market making and the susceptibility to a future beta event remains for any of them.

The question at this point is not whether the rest of the banks have this risk. The going forward questions are more appropriately, how should banks manage their susceptibility and vulnerability to this class of risk? How should insurers and markets price the risk-reward nature of such exposures? And in what direction should regulators aim the going forward definition of safe and sound practices?

IRA has commented a number of times in the past that we believe that risk and stress testing needs to be done in the context of benchmarking as opposed to the myopia of internally focused analysis. In this case, the need is even more acute given the fact that the banks (a) have trillions upon trillions of notional balances exposed and (b) bank counterparties view these derivatives exposures as material investments. So let us look at a catalog of banks so exposed. As is the case whenever it's an IRA analysis, we winnow from a census of all the active banks and look at the individual FDIC Certificate holders. In this particular illustration of systemic vulnerability, the unit institutions with assets over $10 billion - the Dodd-Frank stress testing and reporting threshold - that have derivatives operations that reported a fair value estimates of the traded portion of their exposures in the 1st Quarter of 2012 reporting cycle.

Table 1 - Over $10B Asset FDIC Certificate Holders, 1Q2012

NAME

DERIVATIVESFOR TRADE(Notional) $K

DERIVATIVESNOT FOR TRADE(Notional) $K

TOTAL DERIVATIVES(Notional) $K

JPMORGAN CHASE BANK NA

63,650,436,000

6,735,675,000

70,386,111,000

CITIBANK NATIONAL ASSN

48,584,581,000

3,127,381,000

51,711,962,000

BANK OF AMERICA NA

40,110,943,370

6,229,087,191

46,340,030,561

GOLDMAN SACHS BANK USA

42,270,359,000

483,791,000

42,754,150,000

HSBC BANK USA NATIONAL ASSN

3,777,639,035

624,804,016

4,402,443,051

WELLS FARGO BANK NA

3,085,841,000

603,658,000

3,689,499,000

MORGAN STANLEY BANK NA

2,543,674,000

23,167,000

2,566,841,000

BANK OF NEW YORK MELLON

1,324,329,000

48,569,000

1,372,898,000

STATE STREET BANK&TRUST CO

912,454,345

6,075,991

918,530,336

PNC BANK NATIONAL ASSN

144,085,198

245,974,999

390,060,197

SUNTRUST BANK

212,838,953

54,670,445

267,509,398

NORTHERN TRUST CO

236,579,751

6,063,973

242,643,724

REGIONS BANK

126,481,777

23,191,409

149,673,186

U S BANK NATIONAL ASSN

69,801,437

42,854,555

112,655,992

KEYBANK NATIONAL ASSN

67,703,029

16,040,052

83,743,081

FIFTH THIRD BANK

46,571,169

22,149,571

68,720,740

BRANCH BANKING&TRUST CO

23,132,303

45,959,894

69,092,197

UNION BANK NATIONAL ASSN

40,620,251

10,150,020

50,770,271

RBS CITIZENS NATIONAL ASSN

29,700,353

7,884,815

37,585,168

BOKF NATIONAL ASSN

26,262,687

91,000

26,353,687

CAPITAL ONE NATIONAL ASSN

16,312,132

12,524,821

28,836,953

BMO HARRIS BANK NA

22,921,436

4,375,739

27,297,175

HUNTINGTON NATIONAL BANK

16,632,280

9,623,040

26,255,320

DEUTSCHE BANK TR CO AMERICAS

22,350,000

0

22,350,000

COMERICA BANK

13,346,622

2,384,148

15,730,770

COMPASS BANK

13,950,591

2,307,861

16,258,452

FIRST TENNESSEE BANK NA

12,575,654

7,009,789

19,585,443

MANUFACTURERS&TRADERS TR CO

15,476,745

1,987,079

17,463,824

BANK OF THE WEST

9,671,287

5,306,737

14,978,024

FLAGSTAR BANK FSB

12,541,133

68,954

12,610,087

WEBSTER BANK NATIONAL ASSN

7,557,676

812,904

8,370,580

CITIZENS BANK OF PA

5,909,044

1,659,980

7,569,024

PRIVATEBANK&TRUST CO

6,529,482

426,069

6,955,551

ASSOCIATED BANK NA

3,393,915

1,140,487

4,534,402

FIRST NIAGARA BANK NA

2,414,551

1,942,247

4,356,798

ONEWEST BANK FSB

21,000

4,188,151

4,209,151

ZIONS FIRST NATIONAL BANK

2,533,297

1,007,383

3,540,680

FIRSTMERIT BANK NA

2,498,353

248,033

2,746,386

FROST NATIONAL BANK

1,315,800

90,968

1,406,768

SYNOVUS BANK

1,420,627

337,803

1,758,430

RABOBANK NATIONAL ASSN

1,289,000

141,000

1,430,000

SILICON VALLEY BANK

1,086,802

281,065

1,367,867

FIRST NB OF PENNSYLVANIA

1,398,124

16,282

1,414,406

MORGAN STANLEY PRIVATE BK NA

580,857

436,198

1,017,055

FIRST REPUBLIC BANK

602,163

364,780

966,943

AMEGY BANK NATIONAL ASSN

575,434

129,561

704,995

CALIFORNIA BANK&TRUST

271,851

418,713

690,564

BANK OF HAWAII

538,673

147,407

686,080

COMMERCE BANK

73,942

557,407

631,349

WHITNEY BANK

616,524

0

616,524

ING BANK FSB

4,226

445,031

449,257

STATE FARM BANK FSB

215,171

0

215,171

SIGNATURE BANK

70,000

0

70,000

As can be seen, within this group, there are four large players followed by five medium sized players and then a collection of lesser - but still exposed - participants. All told, fifty three banks in this highly focused peering. Biggest of them in terms of the size of the notional derivatives book is JPMorgan Chase Bank N.A.

What is far more important to understand though is the context of the risk undertaken by JPMorgan versus this peer group. Was it extraordinary? Does analysis of it help us understand where the line of what is systemically unsafe might lie? For that we first turn to leverage. For this we look at the ratio of these institutions' traded derivatives to the fair value envelope of these instruments as reported in their CALL reports. The resulting number is an indicator of "the amount of scrambling that is likely to have to happen in the event of a glitch in the Matrix". The larger the total notional balance size combined with the leveraging factor help quantify the potential nightmare of each billion of realized loss. It's the kind of thing that makes a Tums and Xanax a food group for Chief Risk Officers; maybe for corporate treasurers too.

Notice that there are a variety of strategies with regards to derivatives that begin to be exposed by this relatively simple calculation. There are institutions that clearly pursue very conservative approaches to these instruments and others that make use of them more aggressively. That's not an unexpected result for anyone that has taken the time to understand that the pathways to operating a financial institution are not at all homogeneous, never have been.

Among the big four houses, there seem to be two schools of thought on this ratio, JPMorgan and Citibank electing to run their desks at one ratio and Bank America and Goldman Sachs operating at another one. It implies that a future beta event of similar magnitude as what beset JP Morgan would impact Citi similarly and the other two would have to scramble twice as hard. These are consequence management planning factors and are in fact most useful for costing how much to put into things like compliance oversight and risk taking authorization in the now so as to mitigate consequences if and when.

As one goes down the food chain the differences in strategy become broader straddling the middle ground of the big four with a few institutions electing higher leverage while most seek a more conservative path. Notable among these are the computed ratios of Well Fargo NA and Morgan Stanley NA which exhibit computational differences in the fair value estimates reported to the FDIC. Morgan Stanley basically says the balance sheet value is next to nothing. They may or may not be right but from a benchmarking standpoint, it is a real artifact in the numbers. A number of other smaller institutions also have this reporting approach.

Wells Fargo NA is notable because it pursues the most conservative leveraging approach even as the bank competes head on against its commercial banking competitors. In relative terms, the Wells Fargo desk would have to make a positioning error maybe five times the magnitude of what happened to JPMorgan to realize the same amount of turmoil. Interestingly, it indicates to someone like me to caution that Wells Fargo be the one most on guard against future complacency. Their competitors have incentives to be more hyper-diligent going forward and in the competitive space of derivative zero sum games, that means something.

Finally let's look at how much of the real balance sheet is affected by these derivatives. Using the assumption that the traded leverage ratio is a fair indication of leverage in the remainder of the derivatives book, we can perform a CALL report based apples-to-apples estimate of the book value of these instruments. The caveat is that this analytical assumption may or may not be true but confirming this would have to involve performing a proprietary review to increase the fidelity of the calibration. Still, the question of just how much a derivatives desk impacts the overall portfolio of a bank is an important piece of information to have.

What reveals is a story of concentration risk. Of the fifty-three banks of this peer group, only four have derivatives as a proportion of their total assets exceeding five percent. One of them is JPMorgan Chase NA. Of the remaining three, Citibank NA is similarly sized. Goldman Sachs is its own unique investment banking model. HSBC Bank USA NA is a significantly smaller entity. Notable is that both Bank of America NA and Wells Fargo NA are the asset giants among a group that allocates between two to five percent of the portfolio to these instruments; the remaining banks in the noise indicating hedging as opposed to investment or market making purposes for this asset class. A possible exception might be those banks that reported near zero fair values.

So in context let's look again at JPMorgan Chase. It's definitely the biggest operation dwarfing every other. While the business was run on the higher end of the leverage spectrum, it was not the highest model in operation. In terms of tangible exposure to the balance sheet, it is or was the segment leader. The combination of the three factors is the signature of high susceptibility to event risk and high vulnerability to significant stress in the event that risk manifests. In the end it was a mistake to have ever believed that mass and reputaion were that much protection against this type of risk. It's a painful lesson to be sure and one that other banks should heed based purely an objective assessment of their own numbers in the context of these types of inconvenient truth benchmarks.